Tuesday, January 20, 2009

I ran across an interesting discussion of Chinese external surpluses over on the Peterson Institute website. The article entitled Is China Losing Its Appetite for External Surpluses? contains an interesting discussion about China’s official holdings of foreign exchange reserves. Some are concluding that China is experiencing substantial capital outflows. Nicholas Hardy's take on the issue is that it could be explained by "the use of foreign exchange to clean up the balance sheet of the Agricultural Bank of China (ABC)".

Either way China's holdings of foreign exchange reserves bears close watching in the months ahead as this could become a major issue in both the stock and bond markets. Discussion and analysis of this issue is likely to create increased volatility in the bond markets. It might be a good idea to pay attention. This could also lead to some good trading opportunities.

In the past clean ups of the balance sheets of state-owned banks, the forex used was not transferred from official reserves to Central Huijin (which is now part of the China Investment Corporation, China’s sovereign wealth fund) until just before the clean up was undertaken. I believe this practice has not changed and that centrally funded write-offs of nonperforming loans of the Agricultural Bank of China could account for $90 billion to $100 billion of the “unexplained capital outflow” in the fourth quarter of 2008. Thus the combined centrally financed injection of capital, which has been reported, and nonperforming loan write offs, which have not been reported, for the Agricultural Bank of China could have reduced officially reported official foreign exchange holdings by $110 billion to $120 billion.